Private Foundations Can Work For Some

The Bill & Melinda Gates Foundation is the largest and arguably the best-known private foundation in the United States. While not everyone who creates a successful foundation will be like the Gateses, the couple can be a useful model when deciding whether a private foundation meets your charitable goals. If your aims and resources don’t align with such a project, an alternative may be better.

In the United States, a private foundation is defined as a not-for-profit entity that is not a public charity, as defined by Section 501(c)(3) of the Internal Revenue Code. In practice, this means a private foundation must be funded and controlled by a single individual, family or business, and must be operated exclusively for religious, scientific, literary or educational purposes; for public safety testing; or for the prevention of cruelty to animals or children. Many private foundations support their causes by making grants to organizations invested in those causes.

Individuals, families or businesses may have a variety of reasons for creating private foundations. Foundations offer donors a great deal of control over how contributions are spent, allowing them to steer gifts toward ends they value. Private foundations may also offer prestige and legacy to the founders and to their descendants. Many foundations support public broadcasting, fund building projects at universities or underwrite other educational or arts projects that bear the foundations’ names or acknowledge their generosity.

For families, private foundations can offer useful employment and transmit values from older generations to younger ones. Parents may wish to involve their children in philanthropic decisions or to provide long-term careers operating the foundation for children who may not otherwise need to work. Also, some foundations offer greater visibility and prestige for those who are involved at high levels.

Private foundations also possess certain financial planning features that may be useful for donors. A donor can use a foundation to take an immediate tax deduction for a charitable contribution, even if the foundation does not use the contribution for a grant until some future date. This can allow a donor some flexibility in the timing of a gift.

Creating A Private Foundation

To create a private foundation, you must establish a separate legal entity, either a corporation or a charitable trust. If this sounds complex, it is. Professional assistance is nearly always essential. A team that includes legal and financial advisers will help ensure that your foundation has a solid underpinning. However, here are the basic steps.

Should you decide to create a corporation, you must file articles of incorporation with your organization’s state of domicile. Your foundation will need bylaws, which must be drafted and adopted. You will also need to appoint a board of directors, and officers. Note that some states have regulations specific to the involvement of "interested directors" — people who are compensated for their services or are family members. For example, in California, no more than 49 percent of the corporation’s governing body may be composed of interested directors. If you plan to use your foundation to give status to family members, be careful not to run afoul of these sorts of rules. Typically, corporations have less flexible decision-making processes than do charitable trusts. Corporations will generally set up annual meetings, notices of meetings and structured voting processes.

If you decide on a charitable trust instead, the trust is generally established by drawing up an irrevocable trust document. This makes it easier to impose perpetual restrictions on the foundation’s terms, such as the purpose of the trust or the designation of trustees. Unlike a corporation, a trust-based foundation is not required to file articles of incorporation or secure a waiver of dissolution when it is closed. Nor will you need to work around the 49 percent rule when appointing directors. The major downside, however, is that the foundation will have less flexibility when it comes to changing the governance structure, since that is established at the time the trust document is drawn up.

For either type of foundation, you will also need to submit Form 1023 to the Internal Revenue Service to apply for tax exemption under Section 501(c)(3). This allows the foundation to avoid paying tax on any surplus funds it holds at the end of a year, as well as allowing donors to claim charitable deductions for their contributions. Note that, as of this writing, the IRS is significantly behind in issuing determination letters that confirm the government’s recognition of tax-exempt status. While you can still take a deduction for contributions to a 501(c)(3) organization prior to issuance of the IRS determination letter, if the IRS ultimately denies the request, the deduction will be disallowed. If you are concerned about whether your Form 1023 will be approved, this may influence your decision to contribute.

Section 501(c)(3) organizations are divided into two classes: private foundations and public charities. Compared with those to public charities, donors to private foundations receive a less attractive charitable deduction for their gifts. For property other than cash and stock, contributions to most private foundations are deductible only to the extent of either the donor’s tax basis or the fair market value, whichever is less. There is also a cap on the amount of gifts that can be deducted at all. For cash gifts, the limit is 30 percent of the donor’s adjusted gross income (compared with 50 percent of AGI for gifts to public charities). For appreciated property, the cap is 20 percent of AGI (compared with 30 percent for public charities).

The above limitations apply to “nonoperating foundations,” private foundations that primarily make grants to other charities rather than operating a charitable endeavor themselves. Donors to private operating foundations, those that directly perform charitable activities, and a few nonoperating foundations are entitled to use the more liberal limits that apply to public charities.

Once your foundation is up and running, you and any other officers should be aware of the strict regulatory requirements to which it is subject. Again, professional advisers will be invaluable for ensuring that your foundation meets its obligations. Some limitations include:

Foundations are prohibited from making investments that jeopardize their ability to carry out their stated charitable purposes.

Foundations are prohibited from engaging in or funding legislative lobbying.

They cannot make grants to any entity that is not a U.S. public charity unless they exercise heightened “expenditure responsibility” through inquiry and review.

Foundations must make distributions for charitable purposes each year equal to at least 5 percent of their total investment assets.

No self-dealing is permitted (including insiders purchasing items from the foundation, selling items to the foundation, borrowing money from the foundation or retaining foundation assets on private premises).

Annual reporting and tax filings are mandatory.

In addition to regulation, foundations are subject to ongoing administrative and investment expenses that can quickly add up. Given these factors, private foundations are generally burdensome and expensive to administer, even once they are up and running. There is no hard and fast rule, but general wisdom holds that private foundations are not the best option unless you have at least $2 million to $3 million to donate.

Alternatives To Private Foundations

Depending on the motivation for your charitable gifts, the amount you plan to give and your long-term objectives, other vehicles may be more appropriate.

The least burdensome option may simply be to make your charitable contributions directly to an existing organization. If an organization pursuing your objectives already exists and your primary motivations are to support a specific cause and reduce your tax burden, there may be little reason to reinvent the wheel.

If you are unsure where you want to donate but want to make a tax-deductible gift within a certain time frame, you can also consider donor-advised funds. In these funds, a donor makes contributions that the fund allocates to an investment portfolio. The gift grows in the portfolio, then the donor can recommend grants to particular charitable organizations over time. The initial contribution receives the same tax treatment as gifts to public charities, which is more favorable than for most private foundations. Donoradvised funds are also less expensive and require much less administration than setting up a foundation. Companies such as Charles Schwab, Vanguard and Fidelity all offer them. However, the donor gives up legal control over the gift, meaning that the fund is not obligated to act on grant recommendations.

If you find the idea of charitable giving appealing but also want to ensure a steady source of income, you may consider a charitable remainder trust. This sort of trust provides an income stream back to the grantor (or another designated beneficiary) over a set term or the remainder of the beneficiary’s life. After the term expires, or after the beneficiary’s death, the remaining assets pass to a selected charity or charities. The income stream can be either an annuity or a percentage of the assets in the trust as of December 31 each year. Funding a charitable remainder trust of either type allows you to take an immediate tax deduction equal to the present value of the projected remainder interest (the amount expected to pass to the charity).

Another trust-based option is a charitable lead trust. In this situation, the charity receives the income stream, either as an annuity or as a percentage of the trust’s assets, over a set term or the grantor’s life. At the end of the trust’s term, the remaining assets revert to the grantor or to other designated beneficiaries. If the grantor chooses to pay the tax on the trust’s income, such a trust can provide a charitable deduction equal to the net present value of the annuity at the time of the trust’s creation.

As you can see, private foundations are far from the only option for planned charitable giving. However, for those making large gifts who seek a measure of control, potential long-lived recognition or a way to transmit philanthropic values to other members of their families, private foundations can still serve useful functions in balanced overall financial plans. Once you are aware of the administrative workload and costs involved, you will be better able to weigh the merits of a private foundation and make a decision that is right for you.

Note: This article has been modified from the version appearing in print, in order to clarify that regulations for "interested directors" vary by state.